The clock has finally started ticking down to one of the most substantial changes ever seen in the European market for over-the-counter derivatives, a significant part of the global market worth €692 trillion at the end of June 2013, according to the Bank for International Settlements.

Last month’s decision to authorise Nasdaq OMX’s clearing house under the new regime started the countdown for when these instruments need to be processed via clearing houses under the European Market Infrastructure Regulation.

But Nasdaq OMX’s approval is just one step in a long process. Some of the largest clearing houses are yet to be approved and there is still a long way to go and a number of issues to solve before the start of mandatory swap clearing in Europe.

Achieving authorisation is no mean feat. One clearing house executive told Financial News that his firm’s initial application was more than 1,000 pages long and that related compliance costs accounted for about 15% of its annual investment budget.

Here Financial News lays out what you need to know on how clearing houses are approved and the issues facing market participants as the deadline nears.

• The background: Why do clearing houses need to be re-authorised?

The rules governing clearing houses are included in the European Market Infrastructure Regulation, a package of new rules that aims to reduce systemic risk and improve transparency in the over-the-counter derivatives market.

It’s all part of the push launched by the G20 in 2009 to push trade in derivatives into the open instead of having them arranged privately, the so-called over-the-counter market. All this hopefully means if another bank collapses, such as a repetition of Lehman Brothers, it will be much easier to sort out the vast number of contracts left on its books.

Related

Many clearing houses already process trades for bank-to-bank swap trading, but the introduction of Emir will make this mandatory. Also a much greater range of counterparties, such as asset managers and hedge funds, will also have to process trades via clearing houses.

Domino effect

Clearing houses not only document the trades, they will also step in if a buyer or seller can’t keep their side of the trade, helping reduce the domino effect if one market player collapses.

Clearing houses manage this risk by collecting collateral, or margin, from each counterparty, which is then used to cover losses in the event that one of the firm’s defaults. The collateral used is usually cash or a safe asset such as government bonds.

The clearing house uses its risk-management expertise to calculate the appropriate amount of margin that needs to be paid against each swap contract. A liquid swap contract that trades multiple times a day will command less margin compared with a bespoke swap used to hedge a specific exposure.

All of this means swap market risks are concentrated at clearing houses, rather than being managed informally between counterparties, and means that the clearing houses need to be subject to appropriate regulatory supervision.

As such, Emir required clearing houses to be assessed on issues including risk models, the way they protect buyside assets and stress testing.

Rafael Plata, secretary general of the European Association of Clearing Houses, said: “The re-authorisation of clearing houses under Emir will effectively give clearing houses a European seal of approval. Some clearing houses have been processing swaps for some time, but there is an expectation that Emir will lead to an increase in cleared OTC volumes. Re-authorisation ensures that clearing houses and their users are prepared and have the right set-up in place for OTC clearing.”

• The approval process

Ultimately, clearing houses are governed by national authorities of the country in which they are based. But achieving recognition under Emir requires a further assessment of a clearing house from other national regulators that form a so-called college.

European regulators recognise that a clearing house’s users are based in several countries. If a clearing house runs into financial difficulty, all of its many governments could be affected and clearing house members from across Europe might have to stump up capital to cover losses.

Therefore, under the Emir rules, it is “imperative” that other national regulators are involved in clearing house authorisation to “avoid divergent national measures or practices and obstacles to the proper functioning of the internal market”.

The European Securities and Markets Authority, the European Central Bank and national central banks sit in on the college meetings to ensure the consistent application of Emir, but do not have the power to approve or reject the re-authorisation of clearing houses.

The college membership is based on the other European countries where the clearing house is most active. For example, Nasdaq OMX Clearing’s college comprised regulators from Denmark, Finland, Norway, Sweden and the UK.

John Wilson, global head of OTC clearing at French broker Newedge, said the college approach made sense but added that “this could cause a problem as the composition of the college is based on where the clearing house’s members are based. Therefore, you may not necessarily get a consistency of decision-making nor always have the most qualified experts from around Europe in this process.”

A clearing house is approved if a majority of college members give a positive opinion on the application. If a majority is not achieved, the college members have 30 days to explain why and refer the decision to Esma if needed.

There have been concerns over the way regulators from other countries with competing clearing houses have a say in the approvals.

Eurex Clearing, the Deutsche Börse-owned clearing house that is one of the largest for European futures and options, saw its initial application rejected by its college with some insiders suggesting that national interests may have been at play.

Other people close to Eurex’s approval said questions over how it protected client assets was one of several issues identified by the college.

Rodrigo Buenaventura, head of markets division at Esma, said the watchdog had not seen anything to indicate that national interests were driving discussions: “The college’s discussions were factual and based around in-depth analysis of important aspects of the applications. Maybe some people had expected the process to be lighter, with less discussion at the college level. However, this has nothing to do with national interests but rather with regulators’ interest in ensuring that all EU [clearing houses] are authorised to similar standards.”

Wilson of Newedge said: “The secrecy that surrounds the application process is a challenge. You don’t know what’s gone into the applications and there may have been things we missed when speaking to clearing houses about issues such as the protection of client assets. It would also be useful to know when any concerns are being raised by other national regulators. But most importantly, the impact of clearing house authorisation on the Emir obligations of clearing firms is immediate with no lead times to prepare.”

• From approval to mandatory clearing

As well as ensuring clearing houses can perform their duties effectively in the new swaps market environment, the Emir approval process also starts the clock ticking on when OTC derivatives need to be cleared in Europe.

Once an approval is granted, Esma has up to six months to produce technical guidelines relating to the products the clearing house wants to offer. Several sets of guidelines may run in parallel, depending on when clearing houses are authorised.

At the time of going to press, Nasdaq OMX Clearing, Eurex Clearing and Poland’s KDPW had all achieved authorisation for OTC derivatives clearing.

The European Commission and European Parliament will then have three months each to endorse the standards, after which clearing will be phased in.

Buenaventura said: “After Esma develops, consults and drafts the regulations (technical standards), and after the Commission’s endorsement, the [standards] are subject to a non-objection period by both the European Council and Parliament, after which the clearing obligation will be phased-in per type of counterparties.”

One crucial issue the industry is still grappling with is so-called ‘frontloading’. This requires swap trades agreed between time of an authorisation and the official go-live date for clearing to be retroactively switched from a private deal to a cleared one.

However, this requirement has market participants concerned that trades will be mispriced because cleared and uncleared trades are subject to different funding and capital regimes. Esma is trying to find a solution to the problem that may involve limiting the types of trades that need to frontloaded, but Buenaventura said: “It is too premature to pre-empt the outcome at this stage.”

--This article first appeared in the print edition of Financial News dated April 21, 2014